payday lending regulation
02 Dec 2015I thought I’d jot down some notes/observations after this conversation about payday lending. Payday lending is an interesting subject to me, both because of the demonization of the market and the interesting economics at work – it provides an interesting microcosm of how attempts to regulate markets can backfire and/or fail.
1st premise: people wish to lower the market rates for payday loans (ignoring for the moment the various moral/ethical reasons for this). 2nd premise: the current rate for interest on loans is at a (dynamic) equilibrium allowing for firms to remain viable/profitable given costs of default/administration/etc.
When the equilibrium rate is perceived as being too high, the usual approach is to simply legislate a ceiling cap on rates that can be charged. When you do so, there are two options:
1) You set the rate too high, which creates a schelling point that encourages implicit collusion at this higher rate. There’s some empirical evidence that this already happens.
2) You set the rate too low, which means some portion of the supply (lending firms) will exit the market (voluntarily or go out of business), or reduce the scope or quality of their services.
Thus the two possible outcomes are: harm to low-income borrowers via increased rates, or harm to low-income borrowers via reduced market choice/options.
This all leads back to square one: if you want to eliminate high payday loan rates, there’s only one option: find and provide a better (more efficient) emergency funding option.
The natural and usual rebuttal to this is that regulators simply need to find the “right” rate at which to set the ceiling. I cannot write a better response to this fantasy than Hayek did 70 years ago.
The Hayek drop at the end aged poorly. Since you wrote this, a bunch of states adopted a 36% APR cap (borrowed from the Military Lending Act), and the sky didn’t fall. South Dakota, Colorado, Nebraska, Illinois – some of them deep red states, passing it by ballot initiative with 80%+ approval. Traditional payday storefronts dropped 30-40% from their peak. And the predicted catastrophic loss of credit access? Didn’t clearly materialize. Fintech apps like Earnin and Dave partially filled the gap with smaller advances and different structures. Employer-based earned wage access became a thing. The CFPB tried a federal ability-to-repay rule in 2017 but it got gutted before it ever took effect, and now the CFPB itself may not survive the current administration.
So the “regulators can’t possibly find the right rate” argument ran into the empirical fact that 36% APR worked well enough, across enough states, for long enough, that it’s now the standard benchmark. It didn’t require omniscient central planning – it just required picking a number that made the debt-trap business model unviable. You were right that better alternatives were needed, and some did emerge. But the rate cap did the heavy lifting, not the market.